Head and Shoulders

An Introduction to Charting Patterns

The study of technical analysis is based on the idea that all the current information is already incorporated into the current price of a financial instrument.  With this in mind, many believe the best way to determine future price movements are to study past price action to determine potential future price movements.

Technical analysis is broken down into many categories.  Some of those categories include support and resistance, trend lines, patterns and studies.  While support and resistance along with trend lines describe supply and demand of price action, patterns tell a story which can be recognized from past scenarios.

Charting Patterns

chart patternsPatterns use historical price action recognition to forecast the potential future movements of specific markets.  Analyst use historical prices which generally reflect potential continuation or reversals which give clues about potential future movements.

Trading patterns can be very helpful in determining the next direction for a financial security.  Price action often repeats itself and those who are willing initiate binary options trades when a pattern comes to fruition are likely to benefit from the results of specific patterns

Head and Shoulders Pattern

One of the most recognizable patterns is the head and shoulders pattern.  This pattern is considered reversal pattern that is used by market technicians to determine a market top.

1. A left shoulder is created as the market attempts to make a new high, but is met by selling at a specific resistance level.  The change in the direction is cause by traders who are taking profits as well as those who are shorting the security.

2. The next stage occurs as the market moves lower, but it is quickly met with support and a new uptrend begins generating a new high.  The new highs are viewed as very attractive, as investors are now intrigued by the new powerful up move.

3. After a top forms the market drops but support pushes it higher after it reaches the neckline. As upward price action returns the price of the security will climb creating the right shoulder of the formation.

4. Selling pressure pushes the market back toward the neckline, which is eventually broken, creating a reversal of the current trend.

head and shoulders

Volume plays a strong role in determining the effectiveness of the head and shoulder pattern.  Volume generally rises as the left should is formed, but declines when forming the head pattern.  The increases and decrease of volume are important in determining if a true reversal pattern is forming.  If volume is rising when the head pattern is formed, it reflects the demand for the stock as it hits new highs, and the next move higher will likely not form a shoulder.  For this pattern to be successful a traders needs to wait for the pattern to complete itself.  Volume is difficult to measure for non-exchange instruments such as cash currencies, but even without volume the head and should pattern can be successful.

On the breakdown below the neckline, volume increases creating liquidation the financial product.  The inverted head and shoulder is the reverse of the head and shoulder, and represents a reversal of a downtrend.

The most important part of the pattern is the break down below the neckline.  Traders will often measure the distance from the top of the head to the neckline as the distance that a security will move once it breaks through the neckline.  For example, if the distance from the top of the head to the neckline is $10 per share of a stock, then the price of the stock is likely to fall $10 from the bottom of the neckline once is breaks down.  A breakdown is generally thought of as a closing point, but can vary depending on the type of binary option an investor is looking to trade.

Trading Binary Options Using Head and Shoulder Patterns

The time frames of binary options should coincide with a head and shoulder pattern that uses similar time frames.  For example, if a trader is looking to trade 60-second binary options, he should consider using a 1-minute bar to create his binary options. If the trader is planning on using a daily chart to form a head and shoulder pattern, he should consider trading daily binary options. The reason this is most effective is that the pattern is complete when a closing price breaks through the neckline, and only then is it considered a complete head and shoulder patter.

Leave a Reply